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We were debating whether there was any good news or any light at the end of the tunnel. The best we could come up with was that house prices in the USA might reach a bottom in mid 2009, thus bringing about an end to the recession. Merrill Lynch see this time horizon as probably enough to reach some key economic targets: |
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- household debt servicing to come down from 14% to 10.5% of household income
- household savings to rise to a level of 8%
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Can such a change be achieved within ten months? We have our doubts. These are hard targets in light of the refinancing needs of Fannie Mae and Freddie Mac and of many banks. They are all paying increased borrowing costs, which can only increase the cost of mortgages and decrease the availability of credit. Not a recipe for turning the housing problem around from the current 17 year low in building activity. |
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If that were not enough, holders of prime mortgages but under a system called “ARM” (adjustable rate mortgages) are due to see principal and interest payments move up substantially in the coming months. Some borrowers will return the house keys to their lender, and those who stay put will see their disposable income shrink. Indeed, household spending is now declining, as reports from retailers across the price spectrum confirm. |
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Both Presidential candidates propose government spending expansion AND tax cuts, anything to keep spending up, when sustainable growth first needs an increase in saving. Fortunately economic forces are likely to overcome presidential wishful thinking. There has also been one maverick in the Administration in the person of David Walker, former Comptroller General. After leaving office in March he has been personally leading a campaign to bring home the need for the USA to amend its ways, and is featured in the film “IOUSA”, going on general release this week. We hope that the film will serve as a wake up call to the American public, despite almost every politician refusing to face up to “an inconvenient debt”. The film focuses not only on national debt but also on the under-funding of Social Security and Medicare, issues which we reviewed in this Weekly some years ago. |
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What happens to a country’s currency when its economic weaknesses include a large external trade deficit, an unpopular government persistently spending more than it earns, huge household debt and a deflating housing bubble? The answer is that its currency falls and it has to run high interest rates, causing a recession. That is exactly what is happening to the UK. |
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All the same economic weaknesses apply equally to the USA. In fact, the UK is in trouble precisely because it ventured down the same path as the USA. So why have the same results not come about, i.e. a fall in the exchange rate, high interest rates and a recession? In fact, they are happening in the USA over time and we can but conclude that the recent USD strength cannot last and that the Fed is holding interests rates down for the usual reasons of not facing up to the need to tighten belts. Moreover, the cost of borrowing is rising despite the Fed policy of pretending all is well. |
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We have had to admit that our clients are extremely reluctant to follow our reasoning that long-term yields are likely to fall as recession takes hold. They prefer to remain quite near to cash. For that component of their portfolio, a possible complement to the traditional money-market instruments may be found in floaters issued by financial institutions. Obviously these need to be carefully chosen, not least because the IMF is convinced that a major bank, probably American, is headed for disaster. |
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We have already written at length on Fannie and Freddie, emphasising that their problem is one of insolvency rather than liquidity, since they can borrow from the Fed using their own bonds as collateral. We still see “nationalisation” as probable, but under the new Administration, as the current “liquidity” solution will tide them over. |
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Focus |
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(+) Europe: the euro zone’s GDP declined by 0.2% from the 1st to 2nd quarter. A recession in the UK is expected over the next 6-8 months |
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(–) USA: inflation at its highest in 17 years: 5.6% annually in July |
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(–) Currencies: GBP at its lowest versus USD in 22 months at 1.8577. EUR at its lowest against USD in 6 months at close to 1.47 |
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(!) Precious metals: platinum has fallen to USD 1300/ounce, its lowest since September 2007. Gold has fallen below USD 800.- |
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(–) Argentina: rumours about difficulties in meeting its obligations next year are weighing on the prices of its bonds |
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(–) Russia: RUB down 5% against USD with the Georgian conflict, and USD 7 billion of foreign investment said to have been withdrawn |
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(+) positive for bonds (–) negative for bonds (!) watch out (?) begs the question |
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